Welcome to the Currency War, Part 2: Massive Euro Devaluation

As everyone knows by now, Greece, Spain and the rest of the PIIGS countries
can't fix their economies because they can't devalue. If they were still using
their old national fiat currencies, so goes the conventional wisdom, they
could just mark them down by 30% and instantly see their exports surge and
their deficits shrink. Et voilà, they'd once again be fully-functioning
members of the global economy.

But the euro is beyond their control, leaving them with only austerity, which
in this context is another word for Depression. Hence all the speculation
over radical-but-suddenly-conceivable ideas like a Greek or Spanish exit,
fiscal integration with Germany in charge, and eurobonds guaranteed by the
eurozone as a whole.

This is all wasted effort, however, without the final piece of the puzzle:
The ECB will have to flood the system with newly-created currency, which is
another way of saying that the euro itself will have to be devalued.

Acknowledging this inevitability, Martin Feldstein, Harvard professor and
former chairman of Ronald Reagan's Council of Economic Advisers, calls explicitly
for a euro devaluation in today's Street Journal:

The only way to prevent the dissolution of the euro zone might be a sharp
decline in the value of the euro relative to the dollar and to other currencies.
European politicians' dreams of political union and permanent fiscal transfers
are not realistic solutions to the multiple problems of the euro zone's
peripheral countries -- especially on the tight schedule needed to halt
the collapse of the single currency. The European Central Bank (ECB) may
continue to provide additional liquidity, but experience has already shown
that it cannot reduce sovereign bond yields to sustainable levels.

The peripheral countries -- Italy and Spain, as well as Portugal, Ireland,
Greece, Cyprus and perhaps others -- can only remain in the euro zone if
they solve four difficult problems. First, fiscal deficits must be permanently
lowered to reduce the interest rates on sovereign bonds to levels that
can be financed in the long run. Second, economic growth must be revived
to create employment and sustain political support for that fiscal consolidation.
Third, commercial banks must be recapitalized to stop the deposit runs
and preserve lending capacity. Finally, large trade deficits must be eliminated
so that these countries are not permanently seeking transfers or loans
from foreign creditors.

Politically difficult decisions could solve the first three of these problems.
Less government spending and higher taxes could reduce fiscal deficits.
Changes in labor laws and other institutional barriers to productivity
could produce stronger economic growth. And sufficient growth would give
governments the fiscal capacity to recapitalize their commercial banks.

But implementing these policies would not solve the fourth problem: the
periphery's staggering trade and current-account deficits. Those deficits
reflect the peripheral countries' lower competitiveness after a decade
of slow productivity growth compared to Germany and other northern euro-zone
members.

If the peripheral countries were not locked into the euro but had their
own individual currencies, they could follow the strategy of combining
devaluation and fiscal consolidation that has been successfully adopted
by countries in Latin America and East Asia and more recently by Britain.
Devaluing currencies would boost exports and reduce imports, simultaneously
eliminating trade deficits and spurring growth. Higher GDP would offset
the depressing effect on aggregate demand caused by the higher taxes and
reduced government spending needed to eliminate the fiscal deficit.

This route out of the trade and current-account deficits is not currently
available because the members of the euro zone are locked into a single
currency. That's why euro-zone officials argue that member countries must
force wage levels to decline under the pressure of unemployment so as to
achieve "real devaluations" of as much as 20%. But even with persistent
unemployment rates of more than 20% in Spain and Greece, there has been
little progress in reducing real wages. A strategy of massive real devaluation
through high unemployment is simply not feasible in democratic nations.

This structural impasse could be bypassed if the peripheral countries left
the euro zone, returned to national currencies and devalued. But that dissolution
of the wider euro zone could be avoided by a substantial decline in the
value of the euro versus other non-euro-zone currencies. Euro devaluation
would not change the trade imbalances within the euro zone but would increase
the global exports of the peripheral countries and decrease their imports
from non-euro-zone nations. This in turn would raise the GDP of peripheral
countries, allowing them to achieve positive growth while also reducing
fiscal deficits.

A weaker euro would also render German products even more competitive in
global markets than they are today, increasing Germany's already large
trade surplus with the rest of the world. Increased demand in Germany might
put upward pressure on German wages and prices. But the net effect would
be an even stronger German economy.

Although a decline of the euro would mean higher import prices in euro-zone
countries, it need not mean higher inflation or even a higher overall price
level. The ECB could in principle continue to aim at a 2% inflation rate
with lower prices of domestic goods and services offsetting the higher
prices of imports from outside the euro zone. At worst, the ECB could allow
a one-time pass-through of the higher import costs but prevent any further
increases in inflation rates.

A one-time fall of the euro that eliminates the current-account deficits
of the peripheral countries would not solve the ongoing competitiveness
problem caused by stronger productivity growth in Germany and other northern
countries. But a combination of policies that accelerate productivity growth
in the periphery and slightly slower wage increases there would prevent
a return of large current-account deficits. Eliminating today's large current-account
deficits would make small annual adjustments in the future feasible.

A major decline of the euro does not require explicit action by the ECB
or other euro-zone institutions. If major global investors in euro bonds
conclude that there will be either a breakup of the euro zone or a sharp
decline in the value of the euro, they will reduce their holdings of euros,
driving down its value. In that way, the bond market may by itself deliver
the conditions needed to eliminate the current-account deficits of the
peripheral countries and prevent the dissolution of the euro zone.

Some thoughts

Let's put it bluntly: devaluation is theft. When a country borrows too much
and then marks down its currency it is stealing from its savers and the trading
partners who were naïve enough to think the currency was a trustworthy
store of value. So calls for the eurozone or anyone else to devalue rather
than live within their means are simply enabling the breaking of what should
be seen as a serious promise.

Devaluing the euro will absolutely smooth the integration process -- for about
two weeks, until the US, Japan, China, Brazil and all the other trading nations
that are hurt by a falling euro retaliate with devaluations of their own.
Then we're in Jim Rickards' Currency War III (the first two happened during
the Depression and in the 1970s), complete with rising volatility in prices,
interest rates and pretty much everything else.

Feldstein: "Although a decline of the euro would mean higher import prices
in euro-zone countries, it need not mean higher inflation or even a higher
overall price level. The ECB could in principle continue to aim at a 2%
inflation rate with lower prices of domestic goods and services offsetting
the higher prices of imports from outside the euro zone. At worst, the
ECB could allow a one-time pass-through of the higher import costs but
prevent any further increases in inflation rates." Oh yeah, right.
Central banks have absolute, razor-sharp control of capital flows enabling
them to decide which categories of prices will rise or fall by how much.
Strange that these omnipotent beings allowed today's troubles to happen
in the first place...

Anyhow, one of the guaranteed results of a currency war commencing with today's
stratospheric debt levels and systemic fragility will be capital controls
of a variety and scale never before seen. Each combatant will try to trap
its citizens' wealth at home in order to confiscate it through inflation,
taxation or direct expropriation. So geographic diversification is more important
than ever.

John Rubino edits DollarCollapse.com and has authored or co-authored five
books, including The Money Bubble: What To Do Before It Pops, Clean
Money: Picking Winners in the Green Tech Boom, The Collapse of the Dollar
and How to Profit From It, and How to Profit from the Coming Real Estate
Bust. After earning a Finance MBA from New York University, he spent the
1980s on Wall Street, as a currency trader, equity analyst and junk bond analyst.
During the 1990s he was a featured columnist with TheStreet.com and a frequent
contributor to Individual Investor, Online Investor, and Consumers Digest,
among many other publications. He now writes for CFA Magazine.